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The Shadow Banking System and its Legal Origins

The global financial crisis cannot be understood without closely analyzing the development and the failure of the shadow banking system. Shadow banking, in turn, cannot be understood without examining how law shaped it. This article provides a definition of the shadow banking system and describes the critical role law and legal change played in shaping it.

The shadow banking system describes a web of financial instruments (asset-backed securities, credit derivatives, money market mutual funds, repurchase agreements) that connected commercial and household borrowers to investors in capital markets. This system differs, however, from traditional bond markets and is marked by six features:

- institutions serving a critical intermediation role;- the pooling of financial assets and risks;- “structuring,” or the unbundling and re-bundling of cash streams and risks from financial assets;- maturity transformation;- the creation of assets with theoretically low risk and high liquidity that have many of the features of “money”; and- opacity.

This system provided many of the core economic functions of banking, including supplying credit while offering investors theoretically liquid and stable investments (similar to bank deposit accounts). Yet the system escaped bank regulation. This system ultimately experienced the same types of liquidity and solvency crises as banks, causing massive economic damage.

The article explores how regulatory arbitrage, deregulation (broadly construed), and legal subsidies midwifed the birth of the shadow banking system and fostered its growth.